Consumption tax and corporate product mix decisions

This paper examines how consumption taxes—through the taxation of input goods—can affect firms’ product mix decisions. We study India’s staggered transition from a sales tax, where there was the risk that intermediate inputs are taxed multiple times along the supply chain, to a value-added tax (VAT) that offered credits for taxes paid on inputs. Using detailed product-level data for manufacturing firms and a stacked difference-in-differences design, we find that firms respond to the VAT adoption by narrowing their product scope through reducing vertical integration. These changes reflect a shift away from internal production of inputs, which was tax-induced under the sales tax system, toward greater specialization in the most profitable outputs. We also document that this vertical disintegration leads to lower manufacturing costs, greater profitability, improved investment efficiency, and higher firm value. Our findings highlight how consumption tax design can affect resource allocation within firms and that reducing tax burdens on input goods enhances operational efficiency.